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International Monetary Fund predicts drop in number of countries whose sovereign debt is considered safe could remove $9tn from supply of safe assets by 2016
The International Monetary Fund has warned that the “scramble” for a diminishing pool of safe assets poses a fresh risk to global financial stability.
With demand for rock-solid investments on the increase, the Washington-based IMF said a lack of supply could lead to “more short-term volatility jumps, herding behaviour and runs on sovereign debt”.
The Fund predicted that the drop in the number of countries whose sovereign debt was considered safe could remove $9tn (Â£5.6tn) from the supply of safe assets by 2016, roughly 16% of the total. “Safe-asset demand is expanding at the same time that the universe of what is considered safe is shrinking,” it said.
It was critical of the credit agencies for their willingness to provide the top AAA rating for US mortgage-backed securities and suggested governments should be wary about imposing over-tough financial regulations that would intensify the stampede for risk-free assets. “The shrinking universe of safe assets and the upward-demand pressures have negative implications for global financial stability,” the Fundit said in an article in its latest Global Financial Stability Report, released before next week’s official publication. “Safe-asset scarcity will increase the price of safety and compel investors to move down the safety scale as they scramble to obtain scarce assets.”
Policymakers could help to restore the balance between demand and supply by ensuring financial institutions do not have to acquire too rapidly safe assets to meet new tests for their soundness.
“Although regulatory reforms to make institutions safer are clearly needed, insufficient differentiation across eligible assets to satisfy some regulatory requirements could precipitate unintended cliff effects â€“ sudden drops in the prices â€“ when some safe assets become unsafe and no longer satisfy various regulatory criteria.”
In countries where there were concerns about the high levels of public debt, the Fund encouraged governments to get to grips with budget deficits.
The IMFIt said demand for safe assets was increasing as a result of heightened uncertainty, regulatory reforms to make banks more financially secure and quantitative easing policies adopted by the US Federal Reserve and the Bank of England. The two central banks had become “large holders of long-term government securities, with some risks for safe-asset markets”.
The Fund added: “The sizeable presence of central banks in the long-term government securities market may limit the room for further policy manoeuvre, and may constrain central bank flexibility in smoothly unwinding current monetary policies.”
Ever since the world’s financial markets froze up in August 2007, the three big credit agencies â€“ Standard & Poor’s, Moody’s and Fitch â€“ have been criticised for being too generous in the ratings given to sub-prime mortgage debt.
The Fund said: “The onset of the global financial crisis revealed considerable underpricing of safety linked to over-reliance on credit ratings, adverse incentives from prudential regulations and private-sector practices. The fact that even highly rated assets are not without risk was reaffirmed during the global financial crisis by losses on AAA-rated tranches of mortgage-backed securities and, more recently, by rating downgrades of sovereigns previously considered virtually riskless.”
It added: “In retrospect, high credit ratings were applied too often, both for private and sovereign issuers, and they did not sufficiently differentiate across assets with different underlying qualities.”